Are index funds safe?

Index funds are often touted as being suitable for most investors. It’s easy to see the appeal of them. Hard-earned savings can be eaten away by extortionate fees of active fund managers. The usually low lump sum and monthly contribution amounts appeal to those who wish to start small and save a percentage of their regular income. And passive investors can set up a monthly direct debit and then forget about their savings until retirement. Or can they?

Warren Buffett believes in index trackers, as do many of my fellow Fool’s. However, of late, numerous people have been warning about the dangers of investing in them. I wanted to examine this side of the argument.

Michael Burry, the famed investor from The Big Short, has concerns about passive funds. In Bloomberg, he likened index investing to the subprime CDOs that were instrumental in causing the 2008 financial crisis.

According to Burry, the similarities are caused because the price setting is not being done by “fundamental security-level analysis”. His worry is that passive investors are buying each company at a fixed ratio, rather than considering the actual value of the company in the underlying index.

Although I think index investing – or holding passive funds as part of an investment portfolio – could be a great strategy, I do share some of Burry’s concerns.

The main obstacle for me is – what happens if the markets go into free-fall?

The next bubble?

I question the temperament of a passive fund-holder. An investor with their money held totally in index funds could see their wealth drop by a huge margin. They would lack the benefit of an active fund or self-managed equities, which might enable them to shift assets to other territories or classes.

What would the average passive investor do in that situation? Hold and watch the price fall further, or sell and realise their losses? I think in this situation, a market sell-off could occur. Perhaps, then, we are in the bubble that Burry describes.

Of course, no one can predict what will happen in the market going forward. But in this situation, if the bubble pops, I think the true cool-headed passive investor who continues to buy at these low price points, might be rubbing their hands together.

Spiral?

I think that the problem of passive investors rushing to the door, and causing a downward spiral, could only arise if index funds owned the majority of the market. An estimate in 2017 put the global figure of shares owned by index funds at 18%.

Index funds have their place in the market, just as actively managed funds and personal investors who pick their investments do. Ultimately, though, if an investor can set aside time to learn about investing and keep up to date with the market news, and avoid picking a few losing stocks in the index, their returns should exceed the respective market index.